Which Is A Better Investment: Real Estate Or Stocks?

Classic San Francisco Victorian In Haight DistrictWe’ve got real estate tycoons and we’ve got stock market tycoons. We’ve even got wealthy bond investors such as PIMCO’s Bill Gross who pulls in over $100 million a year, but let’s forget about bonds for now. Now that everything is heading up, I’d like to have an open discussion on which asset class provides the the most amount of wealth over the long run.

With my net worth split roughly 40/30/30 between real estate, stocks, and CDs, you might assume that I like all three asset classes somewhat equally. The fact of the matter is I would much rather have 60% of my net worth in real estate, 35% in stocks, and 5% in CDs at this present time. Unfortunately, shifting one’s net worth around isn’t as easy as snapping one’s fingers. (See: “Recommended Net Worth Allocation By Age And Work Experience“)

It’s important to realize there are no renter or cash tycoons. The return on rent is always -100% every single month. Meanwhile, the return on cash averages a paltry 0.1% nationwide. You can certainly be a wealthy renter with tons of cash in the bank. But your wealth was accumulated through other means so don’t get confused. Having a money strength grade of F- is no way to go.

In this article I will explain to you why I have a preference for real estate over stocks (equities). Both have proven worthy of building great wealth over time, however real estate is going to provide the most return over the next 10 years in my opinion. I’ll do my best to make the case for both asset classes.

REASONS WHY REAL ESTATE IS BETTER THAN STOCKS

1) You are more in control. Every physical real estate investment you make puts you in charge as CEO. As CEO, you are able to make improvements, cut costs (refinance your mortgage), raise rents, and market accordingly. Of course you are still at the mercy of the economic cycle, but overall you have much more leeway in making wealth optimizing decisions. When you invest in a public or private company, you are a minority investor who puts his or her faith in management. Sometimes managers commit fraud or blow their companies to smithereens. Nobody cares more about your investment than you.

2) Leverage with other people’s money. Leverage in a rising market is a wonderful thing. Even if real estate only tracks inflation over the long run, a 3% increase on a 20% downpayment is a 15% return. In five years you will have more than doubled your equity at this rate. Leverage also kills on the way down, but real estate is very difficult to trade so you will most likely stay put unless things get really dire.

3) Tax advantageous. Not only can you deduct the interest on up to $1.1 million in mortgage indebtedness on your primary home, you can also sell your primary home for tax free profits up to $250,000 for singles and $500,000 for married couples if you live in the home for the last two of a five year period. If you are in the 28% or higher tax bracket, it behooves you to own property. All expenses associated with managing your rental properties are also deductible towards your income. Income limits do apply however, so make sure you don’t make much more than ~$166,000 a year total.

4) Tangible asset. Real estate is something you can see, feel, and utilize. Stocks aren’t event pieces of paper anymore, but ticker symbols and numbers. When the world comes to an end, you can seek shelter in your property. Real estate is one of the three pillars for survival, the other two being food and shelter.

5) Easier to analyze and quantify If you can calculate realistic expenses and rental income that’s all you really need when it comes down to valuing a piece of property. If you can borrow at 4% and rent out for a 6% yield, you’ve likely found yourself a winner. Real estate is immediately arbitrageable if you have the financial means to invest. There’s not only the cash flow component but the underlying equity component that helps investors build wealth. Stocks require you to trust what the company reports. There are countless ways for companies to massage their numbers to make things look better than they really are e.g. adjusting accounts receivables, adding one off gains, and using various amortization or depreciation strategies to name a few. Take a look at Zillow.com for the latest estimates, comparables, and sales history. It’s so easy to do research on real estate compared with researching stocks.

6) Less visible volatility. Your house value could be tanking and you would never know it since there isn’t a daily ticker symbol. During bad times, the utility of your home really helps soften the blow as you enjoy your home and create great memories. During the 2008-2009 downturn, I still got to enjoy my vacation property in Lake Tahoe 15-20 days a year even though values were plunging. Meanwhile, looking at the TV or computer screen just made me mad. When your investment is less volatile, it’s much easier to stay the course and not sell at the bottom.

7) A source of pride. Making money for money’s sake is a pretty empty feeling. Every time I drive by my rental properties I feel proud to have made the purchases years ago. I know that my money is working as hard as possible so I don’t have to. Real estate is a constant reminder that taking calculated risks over time pays off. There is an indescribable feeling nobody tells you once you’ve closed on your property. Even though the bank probably owns most of it in the beginning, you literally feel like the King or Queen of your castle. When you die, you can pass on your pride to your children or closest companions to let them create their own memories.

8) More insulated. Real estate is local. If you’ve made a good decision to buy in an economically strong region, you will be more insulated from the national economy or the global economy. Spain blowing up is likely not going to affect the rent you can charge. Look at prices in superstar cities such as Manhattan, Hong Kong, Singapore, London, Paris, and San Francisco. They fall the least, recover the soonest and gain the most. Of course, industries in your area could suddenly disappear and leave you broken as well.

9) The government is on your side. Not only do you get generous mortgage interest tax deductions and tax free profits, you get bailouts if you can’t pay your mortgage. The government also aggressively went after banks to force them to extend loan modifications to bad and good creditors. I even got a free loan mod recently to my surprise. Programs such as HARP 1.0 and HARP 2.0 are allowing folks without hefty downpayments to get in on the action. There are plenty of non-recourse states such as California and Nevada which don’t go after your other assets if you decide to stop paying your mortgage and squat for months. When was the last time the government bailed individual investors out of their stock investments?

home-price-forecast-2013

Various 2013 home price forecasts compiled by The WSJ.

REASONS WHY STOCKS ARE BETTER THAN REAL ESTATE

1) Higher rate of return. Stocks have historically returned ~8% a year compared to 2-4% for real estate over the past 60 years. You can also go on margin to boost your returns, however, I don’t recommend this strategy given your brokerage account will force you to liquidate holdings to come up with cash when things go the other way. Your bank can’t force you to come up with cash or move out so long as you are paying your mortgage.

2) Much more liquid. If you don’t like a stock or need immediate cash, you can easily sell your stock holdings. If you need to cash out of real estate you could potentially take out a home equity line of credit, but it’s costly and takes at least a month.

3) Lower transaction costs. Online transaction costs are under $10 a trade no matter how much you have to buy or sell. The real estate industry is still an oligopoly which still fixes commissions at a ridiculously high level of 5-6%. You would think the invention of Trulia would lower transaction costs, but unfortunately they’ve done very little to help lower expenses. They are in cahoots with the National Association of Realtors. This is part of the reason why I don’t fully trust Zillow.

4) Less work. Real estate takes constant managing due to maintenance, conflicts with neighbors, and tenant rotation. Stocks can literally be left alone forever and pay out dividends to investors. Without maintenance you’re able to focus your attention elsewhere such as spending time with family, your business, or traveling the world. You can easily pay a mutual fund manager 0.5% a year to pick stocks for you or hire a financial advisor at 1% a year.

5) More variety. Unless you are super rich, you can’t own properties in Honolulu, San Francisco, Rio, Amsterdam and all the other great cities of the world. With stocks you can not only invest in different countries, you can also invest in various sectors. A well diversified stock portfolio could very well be less volatile than a property portfolio.

6) Invest in what you use. One of the most fun aspects about the stock market is that you can invest in what you use. Let’s say you are a huge fan of Apple products, McDonald’s cheeseburgers, and Lululemon yoga pants. You can simply buy AAPL, MCD, and  LULU. It’s a great feeling to not only use the products you invest in, but make money off your investments.

7) Tax benefits. Long term capital gains and dividend income are taxed at lower rates than the top three W2 income rates (28%, 33%, 35%). If you can build your financial nut large enough so that the majority of your income comes from dividends, you could lower your marginal tax rate by as much as 20% or so, depending on the current legislation.

8) Hedging is easier. You can protect your real estate investments through insurance. If disaster strikes, it’s often a pain to get your insurance company to pay for damages because the burden is on you to prove your claim. With stocks, you can easily short stocks or buy inverse ETFs to protect your portfolio from downside risk.

CHARACTERISTICS MOST SUITABLE FOR REAL ESTATE AND STOCKS

Real Estate

* Believe wealth is made up of real assets not paper.

* Know where you want to live for at least five years.

* Do not do well in volatile environments.

* Easily spooked by downturns.

* Tend to buy and sell too often. High transaction costs ironically keep you from trading too often.

* Enjoy interacting with people.

* Takes pride in ownership.

* Likes to feel more in control.

Stocks

* Happy to give up control to those who should know better.

* Can stomach volatility.

* Have tremendous discipline not to chase rallies and sell when things are imploding.

* Likes to trade.

* Enjoy studying economics, politics, and researching stocks.

* Don’t want to be tied down.

* Have a limited amount of capital to invest.

NO BAD CHOICES IN A BULL MARKET

The choice between investing in real estate or stocks is like choosing between eating a chocolate cake or a hot fudge sundae. Both are good provided that you don’t go overboard. When you are younger, investing in stocks is easier and makes more sense since you have less money and are more mobile. As you get older you probably want to set some roots so owning at least your primary residence is beneficial. The bottom line is: invest in either asset while you can due to the power of compounding.

My preference is towards real estate because of utility and leverage. If my real estate holdings go up by 4-9% as indicated in the forecasts above, my returns actually increase by 10-35%. I like enjoying my property or at least seeing the things I own. If my vacation property doesn’t make any money, that’s fine because it’s all about the experiences. Driving by my main rental property on the way to play tennis brings joy each time. This particular rental property created a nice amount of wealth over the past 10 years. Once the rental property is paid off, I can use the condo as a pied de terre or an asset that will provide recurring passive income forever.

With stocks, it’s terrific to see portfolios go up. But after a while, it becomes unsatisfying to see more money in my brokerage accounts. The dividend income is nice, but since I’ve got everything I need, including the income to travel and raise a family, the proceeds aren’t translating into anything tangible. Wealth must be tangible in order to be appreciated. Otherwise, wealth is like funny money that can easily disappear when times are bad.

Whatever you do, don’t own nothing. Inflation will rob you of your financial happiness when you are older and less willing or able to work. Own assets that rise with inflation. Let’s just pray the bear market doesn’t return for a long time.

Recommendations For Building Wealth:

* Manage Your Finances In One Place: One of the best way to become financially independent is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and how my net worth is progressing. I can also see how much I’m spending every month. The best tool is their Portfolio Fee Analyzer which runs your investment portfolio through its software to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was paying! There is no better financial tool online that has helped me more to achieve financial freedom.

* Open an online brokerage account. I’ve been investing with E*TRADE for over 10 years and have steadily grown my post-tax portfolio to well over six figures by staying the course. The important thing is to just start as money adds up over time. Sign up with E*TRADE here and you can trade for free for 60 days.

Regards,

Sam

 

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. Surge says

    I have a condo which I lived in for 8 years. Simply got tired of living in the same place, so rented it out.
    Now, we are just enjoying moving to different areas (within the same city of course) every year or so (downtown, beach areas). We are renting where we live and renting out our own real estate.
    Tax-wise -> not the wisest decision, but who wants to be pigeonholed into the same place for the rest of his/her life.

    Are we real estate neutral? There is a strong lifestyle component associated with it.

  2. Sammy says

    Real estate investing is vital to any investment portfolio I agree. However, actually owning physical real estate is too much of a hassle. I am 31 years old, own my own business, have 2 little kids and dont have much time to deal with the baggage that comes with being a land lord.

    I have found REITs are more suited for my lifestyle and investment mentality.

    Dealing with tenants is a hassle at best and a nightmare at worst. Owning even a few rental properties is a second job in and of itself. No such problems with a REIT. Finding tenants, collecting rent, and making repairs are all handled by a professional management team. All you have to do is count the dividend cheques as they roll in.

    Sam you mentioned control.Most real estate investors will point out that the biggest benefit of owning your own properties is control. And this is definitely true. However, I feel like the liquidity of REITs outweighs the benefits of having full control. While leaving the control in the hands of industry experts does not always end well, in general it is a good idea.

    Leverage is often touted as a benefit of owning real estate as you’ve done in this article Sam. Bankers will sometimes allow you to borrow up to 75%, 80%, maybe 100% of the property’s value. But REITs win once again here. Many trusts have leveraged their balance sheet 2:1 or more to enhance returns. Risk-hungry investors looking for more aggressive bets can always finance their purchase with margin

    I am curious about your position on REITs Sam

    • says

      You make some good points, and as I get older, I want to deal LESS with hassle.

      It depends on which REIT, just like it depends on which property.

      I have an extreme bias towards investing in something that is tangible or consumable. Everything else seems like paper wealth that means little.

  3. DrGoldin says

    At the end of the day, the stock market and the real estate market have to provide comparable returns because they compete with each other for investors’ dollars. As a stock investor, I am very glad that (some) people make tons of money in real estate, because that keeps stock prices competitive and allows me to find good values. (The price of a stock is primarily determined by its anticipated return, and if those returns fall short of what you could get in real estate, the share price is inevitably going to fall.)

    Also, it’s misleading to speak of “stocks” and “real estate” as though they were homogenous globs. There are many different ways to invest in either one. In stocks, you could be an essentially passive investor living on (or compounding) dividends from slow-growing blue chips. You could be a more active investor looking for anticipated capital gains. You could even be a day trader. (Serious investors LOVE volatility because they can take advantage of what they regard as mispriced stocks.) You can pick your own stocks; you can invest in baskets of stocks called ETF’s; or you can hire a money manager to invest on your behalf. In real estate, there is comparable variety. You could invest in single-family houses and condos scattered across different zip codes for rental income. You could invest in multi-family properties, which represent a more substantial investment in a single zip code. You could have a management company handle the details for you, or you could drive around collecting everybody’s rent yourself. And of course there’s commercial real estate–everything ranging from a corner bodega to an office building. You could be a sole owner; you could be part of an ownership group.

    What you need to do is find the investment style that suits your temperament, your tolerance of risk, and of course your available capital. It doesn’t really matter whether it’s stocks or real estate (or bonds or alternate assets–although I really can’t recommend bonds right now …). If it works for you, it’s great.

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